Investors Hiring: Mathematicians and Artists Need Apply

How does a fire-hose company from 1870 evolve into a major
aerospace company or a lumber company from 1865 end up as a
mobile phone
business? And what leads a 250-year-old company from the coal mining
industry into auto parts? The answer is rather obvious:
Survival. As Charles Darwin said, It is not the strongest
of the species that survive, nor the most intelligent, but the
one that is most responsive to change.

Investors know all too well that past success is no
guarantee of future success. Markets are constantly
fluctuating, and a good idea today almost certainly wont
be a good idea in a few years time. Its for this
reason that the wild success of certain corporations sows the
seeds of their future failures. The bigger and more successful
a firm is at a given point in time, the more likely it will get
stuck in a certain operating mindset that prioritizes efficiency
gains and asset exploitation at the expense of innovation
and exploration.

Stanford professor emeritus James March argued in his 1991
seminal article 
Exploration and Exploitation in Organizational
Learning, that the basic problem confronting an
organization is to engage in sufficient exploitation to ensure
its current viability and at the same time, devote enough
energy to exploration to ensure its future viability. In
short, the companies that thrive and survive over hundreds of
years are able to adapt to changing environments. They have to
keep making improvements in how they keep the business
running while simultaneously coming up with and rolling
out new ideas. Without this dynamic capability, Marriott would
be known for root beer, Hasbro for carpets and Black &
Decker for bottle caps.

Importantly, research shows that the ability to be both
innovative and efficient is directly associated with firm
performance and long-term survival. Put another way, companies
that have plans to be around for decades seem to take the
mixing of efficiency with innovation quite seriously. In
academia, we refer to this duality as organizational
ambidexterity.

Given all this, you might naturally assume that most
institutional investment organizations  many of which
have been around for 50 years or more  have focused
intently on innovation and evolution in the face of market
volatility and technology changes. But youd be wrong.

In reality, institutional investment organizations often
enjoy a monopoly over their asset base, as sponsors rarely set
up multiple and competing institutional investment
organizations (compare
Sweden AP Funds). As such, the threat of extinction does
not motivate these organizations as it does the private sector.
In fact, institutional investors are often allergic to change.
They prefer the company of a good herd. They tend to focus on
managing political and career risk instead of investment risks.
They are often dependent on external service providers, which
means their ability to change their own organizations is
limited. To give them some credit, many are beholden to the
prudent man rule; with its antiquated notion of fiduciary
duty that roots organizations in a mindset that rejects an
enduring focus on innovation.

And all this occurs despite clear evidence that innovation
within the business of institutional investment offers
significant rewards, much as it does in other industries. Most
of the worlds top institutional investors got to be top
institutional investors by doing something distinctly different
from their predecessors. The
endowment model saw university endowments move aggressively
into a diversified portfolio of risky alternatives. The
Canadian model saw public pension funds aggressively move
assets in-house. The
Dutch model saw industry funds aggressively match assets to
liabilities. And there are others. What they all have in common
is innovation. They started out producing investment returns
one way and evolved over the years to produce investment
returns in an entirely new one.

That last sentence reminds me that I should pause and
refresh readers on the unique nature of investment production
functions. All institutional investors produce the same thing:
money. They take an initial stock of money  what
wed call financial capital  and they try to
generate more money by convincing developers, corporations,
entrepreneurs or any other capital seeker to accept their money
and then give them more after a given time period. How do
investors achieve this feat? For the most part, they all use
the same inputs. To their initial stock of money they add
healthy dose of human capital, a dash of informational
advantage, and a smattering of policies, processes and
procedures. And, in the end, they hope that their production
function can produce more money than their peers, given similar
inputs.

Innovation in the business of institutional investment,
then, is really about improving the quality of inputs and
changing how those inputs are combined and mobilized. It may
sound relatively simple. Its not.

This is partly because theres not a lot of research
and understanding on how these investment inputs should be
combined. Granted, there are many studies to guide investment
professionals on investing but surprisingly, there are very few
studies on the actual
production of investment returns. Unlike the models and
theories that underpin modern portfolio management, the
production of returns depends on motivating employees, managing
technological systems and even developing procedures and norms
for decision-making. Success is about great people, data and
decision making and then changing what is meant by
great over time to reflect environmental
conditions.

Today, most institutional investors are unable to do this,
which is a shame. As is the case with other industries, the
success of institutional investors demands a
mountain of innovation and adaptation. In fact, I think the
next big model of institutional investment will be based
specifically on the ability to innovate.

In other words, the investment organization that can best
adapt to changing market conditions will come to be known as
the adaptive model; rooted in the aggressive
development of new ideas rather than a streamlining and
repackaging of old ones.

At its heart, this is about asking Giants
to engage in experimentation and pilot projects that may only
have payoffs in the distant future. This wont be easy, as
research shows clearly that building organizations that can be
efficient and innovative is challenging and demands a cultural
focus that embraces exploration. But, in a hundred years,
itll be worth it.